Mutual funds sing Aretha Franklin off-key

Commentary: Why the industry is tone deaf on regulation

No one is going to sing a love song to the mutual fund industry, but after this week if anyone was tempted to, the hook would go like this:

“You make me feel like a natural person.”

With all due apologies to Aretha Franklin, companies like Fidelity Investments, BlackRock, Vanguard and others were not so much invoking the Queen of Soul this week as proving that they have no soul themselves, when they combined to comment on the Securities and Exchange Commission’s proposed reforms to money-market funds.

For investors, it would be easy to ignore the whole thing — most of the news media did — were it not for being called a “natural person,” which has nothing at all to do with nature.

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Suppress your snickers at that description while I give you the background and say how the big fund companies came to use it.

Money-market funds are supposed to be boring, pain-free investments, a safe place to park cash. Shares are priced at a constant $1; any interest the fund earns that would otherwise raise the price gets shaved off and reinvested to keep the value stable. If the fund were to lose money — a situation that would typically result in the share price dropping — the fund sponsor typically steps in to make sure that the fund does not “break the buck.”

In 2008, however, the nation’s oldest and largest money fund, Reserve Primary, broke the buck in the wake of the Lehman Brothers bankruptcy, which started a run of investors fleeing money funds, a dangerously destabilizing event for the entire economy.

Investors who stuck with Reserve Primary ultimately lost three cents on the dollar, disheartening but — considering the positive total return many long-term holders experienced for years in the fund — not life-changing. In fact, even after the loss, many investors did better in Reserve Primary than they would have in funds that went trouble-free.

Small losses in safe investments are bad; economic chaos is much worse.

Thus, in 2010, the SEC adopted rules requiring greater transparency and forcing money funds to invest in more liquid assets with higher credit ratings and shorter maturities. The fund industry supported that move, but wanted changes to stop there.

Ultimately, however, a watered-down proposal was sent up the flagpole earlier this year. The first key provision of the proposal affects institutional prime funds — which invest in more than just government debt and account for more than $1 trillion in assets — abandoning the stable $1 value for a floating net asset value.

The big-money moves — redemptions of the $1 million-plus variety — occur in these funds; the idea behind a floating-value is that if an institutional money fund is stuck with bad paper, institutions can’t beat the problem by exiting the fund, thus curtailing the rush to the exits.

The SEC wants to define a “retail fund” as one that “does not permit any shareholder of record to redeem more than $1 million of redeemable securities on any one business day,” which seems an easy way to help root out the big boys and help stabilize money funds amid a crisis.

The fund companies instead proposed defining a retail fund as one that “limits beneficial ownership interest to natural persons.”

In legal terms, “natural person” is a way to say “a real human being.” By comparison, the convoluted definitions of the jurisprudence system allow for a “legal person” to include a private business entity or a public organization.

The comment letter from the big companies is compelling in one sense; it highlights how institutional funds faced much greater redemption activity at the crux of the 2008 financial crisis.

But the argument that adding in the $1 million redemption limit would create additional costs and record keeping issues is a non-starter.

A limit is a limit. It’s not hard to enforce and it should not be hard to track. For all of the fund firms’ talk of having to track customer accounts and more, the truth is that they simply need to enforce a limit. All the rest is poppycock.

That’s why this talk of “natural persons” feels entirely unnatural, as if the big fund firms — and they all signed the comment letter as entities and not as real people — want to keep open a loophole that allows for some slick operators to play games.

To shareholders, the truth may be that there is no real difference; individual investors won’t notice much difference if their fund is limited to natural persons or if it instead restricts daily redemptions to $1 million.

Either way, they get the protections that regulators have been hoping for, a bit of cushion from a possible market run when trouble happens again.

It’s long past time to get those protections in place. An acceptable solution is on the table; it’s time for all sides to stop grandstanding and get this done.

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